Practice problem--it's very helpful ~

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School

University of Toronto Mississauga

Department

Economics

Course

ECO359H5

Professor

Sun

Semester

Winter

Description

ECO3592011 UniversityofToronto PracticeProblems3 DepartmentofEconomics ECO 359 Practice Problems 3 Solutions to selected Textbook questions Question 9.1 PR Electronics Inc. has developed a new Pink-Ray DVD. If the Pink-Ray DVD is successful, the present value of the payoff (when the product is brought to the market) is $20 million. If the Pink-Ray DV fails, the present value of the payoff is $5 million. If the product goes directly to the market, there is a 50% chance of success. Alternatively, PR can delay the launch by one year and spend $2 million to test market of the Pink-Ray DVD. Testing market would allow the firm to improve the product and increase the probability of success to 75%. The appropriate discount rate is 15%. Should the firm conduct test marketing? Answer: Plot the tree diagram of the real options as follows: Now(year0) 50% 20M Year1 Godirectly 5M 50% Start 75% 20M TestMarket H2M 5M 25% Calculate the NPV of the expected payoff for the option of g